Q:  What are the core beliefs of your investment philosophy? A : We buy stocks and invest in individual companies. Our strategy is very similar for both funds we manage, multi cap and small cap. We shift back and forth between value and growth, wherever we see an opportunity. But above all, we are looking to invest in businesses or sectors that have emerging and sustained pricing power. We also believe that understanding market perception is important. Q:  What is your investment process? A : We use a bottoms-up investment strategy. This is where we initially focus on the inter-workings of the companies we invest in and how outside influences affect their business. Knowing how the economy and macro environment are influencing the individual companies we are researching as an investment opportunity is critical. We speak to or meet with suppliers and various industry participants within the different sectors and try to understand how each is impacted without spending a lot of time forecasting the direction of the economy. Next, we build financial models and forecast earnings and cash flow. We often uncover unique opportunities especially in volatile markets. At times we uncover an opportunity where there may be a disconnect between what the market perceives and what the reality is by using this bottoms-up, go anywhere approach. Q:  What is your research process? A : In the small cap sector, we are believers that there are inefficiencies in the market. When we get into periods of extreme market volatility like the one we have had over the past 12 months, often times, with the smaller companies, these inefficiencies become exaggerated from one degree to another and that creates opportunities. When we look at a company or an industry we look at pricing power. That is a big theme in studying the various companies that we may invest in. Pricing power is very important in that it usually tells a lot about the underlying business characteristics and the overall health of the industry. And a great deal about the competitive landscape and the ability of the company to improve their profit margins, which can then lead to earnings growth, earnings multiple expansion and higher returns on equity. These are the drivers of stock prices. For example, in the multi cap fund we started buying railroad stocks in the summer of 2003. We came across the railroad operator Burlington Northern Santa Fe Corp and found that the company started to raise prices. Suddenly, the rail industry was experiencing pricing power for the first time in about thirty years. Freight rates had been flat since the early eighties. The railroads had survived by becoming more efficient. As we went through and uncovered why and how we found high barriers to entry and a low cost provider of transportation services. We ended up owning Union Pacific, Norfolk Southern Corporation and a few of the other railroad stocks. Q:  Once you identify an industry or a company that has earnings power, what signals do you look for when earnings power begins to diminish? A : Some of the key factors we look at are barriers to entry, access to capital, competitor threats and substitution effect. How long it would take a competitor or someone new entering that market to replicate the company’s product or technology or gain market share in some meaningful way. Is it a real possibility and is there capital available to do so? Those are the primary indicators we look for when evaluating the quality and the longevity of pricing power. By continuing to monitor pricing power we found a very similar situation start to emerge in 2005 with deepwater drillers. Companies like Transocean Inc. demonstrated solid day rate pricing power on their drilling rigs. We researched how long it would take to order a new rig, the underlying dynamics of the deepwater drilling space and why day rates were climbing. After evaluating what the longevity of those price increases were, we believed we had found some interesting investment opportunities. More recently, we have started to find opportunities in the airlines industry, where for the first time in about twenty-five years, carriers are starting to raise their prices. They have to in order to survive, and as capacity is rationalized, it will likely demonstrate that airlines are in the very early stages of getting healthier. It is still going to take some time but we are starting to see pricing power. Another company, Cal-Maine Foods, Inc. the largest egg producer in the United States, has over 15% of the U.S. market share for fresh eggs. They have demonstrated good pricing power, benefiting from many smaller producers going out of business in the last few years as a result of new regulations in the industry as well as higher feed costs. Egg prices have risen faster than some output costs. The margin improvement, earnings growth, and stocks have done well. We still think there is room for multiple expansions in the stock. Q:  Can you give us an example of when you start looking at a company like Cal-Maine? A : I think we look at all the variables inside and outside the company, but we start with the bottoms-up approach. There are no other public competitors in the egg business so Cal-Maine gets little Wall Street coverage, even though they are the largest egg producer in the country. New industry regulations now limit the number of laying hens - chickens that produce eggs - allowed in each cage. Previously, two chickens were housed in a single cage, but now only one hen per pen is allowed. That reduced capacity with many of the smaller producers that were unable to invest new capital into adding enough cages and facilities to house more laying hens. This new regulation became a huge factor in Cal-Maine’s pricing power. So again, we evaluate where a company stands by looking at the value of management, what the balance sheets indicate, underlying cash flow, and current events in the business and industry. We have several analysts that look for new investment opportunities as well as monitor our existing holdings. For the most part, each analyst has their area or areas of expertise, but each also follows multiple industry silos. I think that gives us a unique perspective to understand what is going on in the broader market, how it is affecting companies, and what the risk/reward tradeoff is. It helps us put everything into perspective. In many cases, if you have an analyst following a single industry, they do not always have the perspective to understand how capital is flowing from sector-to-sector and how risk is re-evaluated in the market each day. For example, an analyst following only one sector of stocks may know everything about an industry and the companies in it and they may be very good at figuring out the reality, but not as capable of understanding the market’s perception as a whole. Being able to size up the reality and understand the market psychology and perception is critical. Q:  How do you see the portfolio? What kind of benchmark do you use? A : The Hodges Fund, which has approximately $700 million in it currently, is generally classified by fund rating companies in the midcap blend category. Our benchmark there is the S&P500 index. In the Hodges Small Cap Fund, we are classified as a small cap core and the Russell 2000 index is our benchmark for that fund. Q:  How many holdings do you have and what kind of turnover do you have in both of the funds? A : The turnover varies. In the Hodges Fund, our multi cap fund, it can vary from year-to-year depending on the market and what is happening from a strategic standpoint, which is constantly changing. On average, it has run around 50% of the portfolio. In the Hodges Fund, we typically have anywhere from 75 to 100 stocks. In the small cap fund, it’s a bit lower, with somewhere between 35 to 45 stocks. Q:  How do you view the risks? A : We evaluate risk as the prospect for a company to generate future earnings. At the end of the day, when you buy a stock, you are buying the present value of earnings. What the market is willing to pay for that present value is constantly fluctuating but the components that go into the risk-free rate and how risk is viewed by the market is certainly real. Q:  What is the average holding period that you have in your small cap or the mid cap funds? A : Typically, in both of the funds, we go into most securities with at least an 18-month time horizon. Sometimes we will buy securities with a holdings period that is maybe a little bit shorter. We will also occasionally buy securities we think look good on a two or three-year time horizon, which would be more in the category of a turnaround situation of a contrarian type investment. Q:  Do you think that is long enough to do all of the analysis on a discounted cash flow basis that applies to the companies or holdings that have to go through at least one business cycle for you to benefit from it which could be anywhere between 5 to 7 years? A : It depends. We will model out more than 18 months, but as far as putting together an investment thesis we think is going to be a catalyst in helping to unlock the value and the market’s perception, we usually base that on a 12-to-18 month time horizon. That does not mean we will not hold the stock longer, but we need to have a reason.